Introduction to Macroeconomics

Macroeconomics studies the performance of the economy as a whole derived by aggregating the performance by households, business firms, and governments. A logical treatment of macroeconomics is consistent with the assumptions of microeconomic behavior.

The Art and Science of Economic Analysis

A. Rational Self-Interest

1. A key assumption in economics is that individuals make rational choices that they perceive to be in their best interests. 2. The best choices frequently occur under conditions of uncertainty. 3. Rational self-interest is not blind materialism or greed, but includes the welfare of the family, friends, and perhaps the poor of the world. 4. Even charity required economic choices.

B. Use of an economic theory, or economic model

1. A theory or model simplifies reality in order to make predictions about the real world. 2. A model captures the important elements of the problem under study without spelling out every detail. 3. A theory can be presented verbally, graphically, or mathematically.

C. The Scientific Method

2. The first step is to define the key variables that are relevant to the economic problem under consideration. 3. The second step is to specify the assumptions under which the theory is to apply. One assumption is the other-things-constant assumption that allows us to isolate the influence of key variables. Other assumptions are behavioral assumptions regarding individual behavior. 4. The third step is to a formulate hypothesis that implies causality, i.e. if…, then… statements. This is called a positive economic statement (rather than a normative economic statement.) 5. The fourth step is to test the theory by confronting its predictions with the evidence. Competing theories are evaluated on the basis of their ability to predict. 6. Economists rely on the scientific method, but they tell stories about how they think the world works. These stories help breathe life into economic theory and allow economists to personalize abstract ideas.

1 Predicting average behavior and some pitfalls of faulty economic analysis

1. Macroeconomic behavior may be predicted more accurately because an group average may offset the unusual behavior of individuals who are “outliers.” 2. The fallacy of composition, however, may be a problem in generalizing from the individual to a group. For example, if one household saves they will be able to consume more in the future, but if all households save then national income falls and less consumption may occur in the future. 3. Other pitfalls in economic analysis include the assumption that association (correlation) implies causality and ignoring secondary effects of policies that may be perverse. 4. It is also possible that irrational behavior may be cumulative. Keynes’ ‘animal spirits’ and Greenspan’s “irrational exuberance.”

In macroeconomics we study how decisions coordinated by markets in the entire economy join together to determine economy-wide aggregates like employment and growth. Before we can go on, it is important to understand what economic actors are interacting in these markets and their relationships to one another.

Four (broadly defined) economic actors are: 1. Households 2. Business Firms 3. Governments 4. The Rest of the World" GDP accounts are separated into components based on the Households are consumers and savers that maximize utility over time. Business firms are producers and investors that maximize profits over time. Governments consume, save and dissave, and invest based on political motives. The Rest of the World interacts with the other domestic actors in many ways.

The Big Three Concepts of Macroeconomics 1. The unemployment rate 2. The inflation rate 3. Productivity growth (change in output per man-hour)

UNEMPLOYMENT

A. Unemployment has obvious costs: 1. Personal- loss of paycheck, loss of personal identity, linked to crime, suicide, heart disease, and mental illness. 2. Costs to society- less goods/services produced.

B. Measuring Unemployment: 1. Adult population – civilian (non-military), non-institutional (not in mental hospital or prison), adult (16 or over) population. 2. Labor Force – Those in the adult population either working or looking for work.

2 -You are counted as unemployed if you have no job but have looked for work at least once during the preceding four weeks. 3. Unemployment Rate – percentage of those in the labor force who are unemployed.

Not counted in the labor force: 1. retired 2. chose to stay home, care for children 3. full-time students 4. do not want to work 5. unable to work 6. discouraged worker – A person who has dropped out of the labor force because of lack of success in finding a job. 7. Part-time workers – counted as employed even if they would like to work full- time.

C. How well does the unemployment rate measure unemployment? 1. Because the unemployment rate does not count 6,7 à it may underestimate the true extent of unemployment. 2. Official data also ignores the problem of Underemployment – A situation in which workers are overqualified for their jobs or work fewer hours than they would prefer. 3. On the other hand, because benefits require that people look for work, some people may be pretending to search. Their inclusion tends to overstate the official unemployment figures. **Most experts tend to believe that unemployment figures underestimate the level of unemployment.

D. What the unemployment rate does not tell us. 1. Unemployment Rate does not tell us who is unemployed. -Unemployment rates higher among African Americans than whites. -Unemployment rates higher among teenagers than those over 20. 2. Unemployment Rate does not tell us how long people remain unemployed. 1998- average duration 14.5 weeks. Typically, a rise in unemployment rate reflects both a larger number of unemployed and a longer duration of unemployment. 3. Unemployment Rate does not show the differences in unemployment across the country.

E. Types of Unemployment 1. Frictional Unemployment – Unemployment that arises because of the time needed to match qualified job seekers with available job openings. Workers do not always accept the first job they get. Employers do not always hire the first applicant. The time required for labor suppliers and labor demanders together results in frictional unemployment. Usually short-term, voluntary.

3 2. Structural Unemployment – Unemployment that arises because The skills demanded by employers do not match the skills of the unemployed, or The unemployed do not live where the jobs are located. 3. Seasonal Unemployment – Unemployment caused by seasonal shifts in labor supply and demand. During winter, what happens to the demand for lifeguards, golf instructors, etc..? 4. Cyclical Unemployment – Unemployment that fluctuates with the business cycle, increasing during recessions and decreasing during expansions. Government policies to stimulate Aggregate Demand during recessions are aimed at reducing cyclical unemployment. 5. Full employment (the natural rate of unemployment) occurs when only frictional, structural, and seasonal unemployment exist.

F. International Comparisons of Unemployment 1. Unemployment rates tend to be higher in the U.K.- ratio of unemployment benefits to average pay are higher. 2. Difficult to make comparisons between countries because of different definitions of unemployment and different methods for collecting data. Some countries also have laws limiting layoffs and other policies/laws that could affect the unemployment rate.

INFLATION

A. What is inflation? 1. Inflation – A sustained increase in the average level of prices. 2. Hyperinflation –A very high rate of inflation 3. Deflation - A sustained decrease in the price level 4. Disinflation – A reduction in the rate of inflation

The annual inflation rate is the percentage increase in the price level between one year and the next.

B. Sources of Inflation 1. Demand-pull inflation – A sustained rise in the price level caused by increases in aggregate demand. 2. Cost-push inflation – A sustained rise in the price level caused by reductions in aggregate supply.

C. Problems with Inflation 1. Anticipated v. Unanticipated Inflation Unanticipated inflation creates more problems for the economy than does anticipated inflation. Inflation higher than expected à Winners are those who contracted to pay a price that doesn’t reflect the higher inflation. Losers are those who agreed to sell at that price. Inflation lower than expected à Winners are those who contracted to sell at a given price that anticipates higher inflation. Losers are those who agreed to buy at that price.

4 Example: -Inflation next year is expected to be 3%.--You agree to work next year for a nominal wage 3% higher than your wage this year. (Expect real wage to be unchanged) What if inflation is 5%? Your real wage will fall. Your employer is the winner, and you are the loser. What if inflation is 2%? Your real wage will increase. You are the winner, and your employer is the loser. (Similar effects of effects inflation on nominal versus real interest rates.) These arbitrary gains and losses associated with unanticipated inflation are one of the reasons inflation is not good. 2. Transaction Costs of Variable Inflation: Inflation creates uncertainty about the purchasing power of the dollar. Planning becomes difficult. Managers must shift attention from production to anticipating the effects of inflation. The transaction costs of drawing up contracts increases as inflation becomes more unpredictable.

PRODUCTIVITY GROWTH

A. Productivity is measured by the ratio of output per worker-hour of work. It is approximately equal to output per capita in the long-run.

B. Measuring output (Gross Domestic Product) 1. National income accounting is based on double-entry bookkeeping. One persons spending is another persons income (receipts). Hence, it can be measured two ways: the expenditure approach or the income approach. 2. GDP—The Expenditure Approach adds all expenditure on final goods/services in a given year. C. Aggregate expenditure can be divided into 4 components: 1. Consumption (personal consumption expenditures)- All household purchases of final goods and services. 2. Investment (gross private domestic investment) – The purchase of new plants, new equipment, new buildings, new residences, and net additions to inventories. (Spending on current production that is not used for current consumption.) ***Investment does not include purchases of existing buildings, machines, and financial assets (stocks and bonds) 3. Government purchases (Government consumption and gross Investment)- spending at all levels of government for goods and services; government outlays minus transfer payments. 4. Net Exports- value of US exports minus the value of US imports. (includes invisibles like tourism)

Aggregate Expenditure =GDP = C + I + G + (X-M)

C. GDP based on the Income Approach - Adding up all payments to resource owners (Aggregate Income = Y)

Aggregate Income Y = C + I + G + (X-M)

5 ACTUAL AND NATURAL REAL GDP

1. Actual real GDP is what the economy is actually producing at any given time. 2. Natural real GDP is what the economy produces when operating at its potential, so that there is no tendency for inflation to accelerate or decelerate. 3. The natural rate of unemployment (also called NAIRU) designates the unemployment rate that occurs with no tendency for inflation to accelerate or decelerate. 4. The difference between actual real GDP and the natural real GDP is called the real GDP “gap”.

A. The Short-run versus the Long-run in Macroeconomics 1. The short-run is primarily concerned with stability associated with the business cycle. 2. The long-run is primarily concerned with economic growth.

B. A business cycle recession or expansion occurs when the economy is operating below or above its long-run trend rate of growth in potential output, resulting in a recessionary or inflationary “gap.”

C. Long-run economic growth occurs with productivity growth and growth in man- hours results in a higher natural rate of output.

THE CIRCULAR FLOW OF INCOME AND EXPENDITURE

A Income received in the production of goods and services adds to expenditure for domestic and net foreign goods in what is called the circular flow model. 1. In the circular flow model, the rate of leakages from the income stream must equal the rate of injections into the income stream. 2. Total leakages from the income stream are S + T + M 3. Total injections into the income stream are I + G + X 4. Hence, the following relationship holds:

S + T = I + G + (X – M)

C. How does a change in the government budget impact the private economy?

T – G = I + NX – S ‘ Hence, a higher the budget deficit (negative public savings) must be matched by a increase in private savings, a reduction in domestic investment, a reduction in the trade balance, or some combination. (Note a trade deficit results in a capital account surplus that provides foreign savings to finance our government deficit. Can this persist in the long-run?)